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Wednesday, September 13, 2006

Peak Bubble: A Time To Remember

"If you paid your mortgage off, it means you probably did not manage your funds efficiently over the years," said David Lereah, chief economist of the National Association of Realtors and author of "Are You Missing the Real Estate Boom?" "It's as if you had 500,000 dollar bills stuffed in your mattress."

51 comments:

Yup, that's unsophisticated lil' ol' me! Back when dot-coms were hot, I stayed out -- again a very unsophisticated thing to do. My B-I-L used to cackle and rub it in with, "I just can't believe how much money I made in the stock market today!" every time we'd see each other. After the crash, I never heard another word and I never said a thing. Today he has to work and I don't.

Yeah, I feel like a real hillbilly, having paid off my mortgage and then having cashed out entirely. Now I'm in brain-dead CDs, waiting for lower housing prices. Foolish, they'd say but hey, I'm just an unsophisticated rube trying to make his way in the world.

a further quote from the same article, "Anthony Hsieh, chief executive of LendingTree Loans, an Internet-based mortgage company, used a more disparaging term. "If you own your own home free and clear, people will often refer to you as a fool. All that money sitting there, doing nothing."

I am a bubblehead, but David Learah is right, sort of. He is referring to the principles of books like The Millionaire Next Door and The Truth About Money (Ric Edelman). These advisors explain how your house is an expense that you should always try to limit/keep as low as possible. The premise is simply that if you are paying off your mortgage ahead of time then you are not putting that cash towards REAL investments. See, people like Edelman understand that the historical return on real estate is just above inflation (something David Learah also stated earlier this week). You would do better in an index fund (and if you could do better in stocks than the market as a whole, you would be even farther ahead).

The Suze Orman crowd says to pay off your mortgage as fast as you can and think of how free you will free without a mortgage! But this is an emotional argument, not a financial, numbers-driven one. The math clearly demonstrates that by investing (i.e., keeping your cash) you end up with more liquid $, than paying off a mortgage ahead of time and then trying to pay catch up with your investments/retirement. After all, as we all know, time is money.

With all that said, that does not necessarily mean that if you pay off your mortgage you were unsophisticated. After all, it was an obligation you were required to meet and at some point it should be completely paid off. And in some cases, for some reasons, it is necessary to clear debt-capacity, if you need to take on another loan. Main gist, pay your mortgage and nothing more, if you have a crappy rate, refinance when rates come down, and make the sacrifices necessary to invest in a diversified portfolio.

let's see - Sold our house - $560 in treasurydirect.gov earning an average over 5% - no GA income tax on earning - renting for less than earnings on treasury bonds - watching house prices come down - builders now cutting $15-20K on new houses - wow are we dummies or what!

WhiteTower said... "In the never-land of housingheads, carrying debt has no opportunity costs -- as if there's nothing else you could have done with your $500,000."

uhhhh, Whitetower, you just made a case FOR not paying down your mortgage too quickly ... read Warmredblanket's explanation why a slow paydown (or even "no" paydown) can be better than a fast or complete paydown. I know we housing heads often discuss how if you buy vs. rent you eventually don't have a payment at all to make. That is really for illustrative purposes to bring home the fact that when you own at least some of that money is being paid back to yourself. In reality, it is better to take that money invest it in an assest and not leave it in your home which is really an expense which should be minimized over the long haul.

I don't get your point. I believe in maxing out retirement vehicles, savings, investment and paying off your home. There is no reason all cannot be accomplished simultaneously UNLESS you buy too much house or car etc. This is the point of the Millionaire Next Door - live below your means, don't compete with the Jones' family, forego the fancy new cars and clothes.

Well, since I have a 4.875% 15 yr fixed mortgage*, paying it off early makes no real sense. But you cannot say that having 100% equity in your home doesn't bring you any returns. The return that you recieve is the rental equivalent value of your home. That is the same return that you were receiving over the course of your loan.

*the 15 year term is relevent because even in the early years of this loan, I'm paying more principal than interest. The closer that you are to paying off your house, the smaller returns that you get from paying extra principal.

I guess I am one of those "unsophisticated" ones also. Many can argue the merits or demerits of paying your mortgage off. I personnaly have never felt freer being released of that burden from around my neck. Debt, in my view, is no more than slavery. We must remember where Lereah's viewpoint is coming from. He is a real estate pimp and could care less about you and I do as individuals. More loans made, the more money the industry he pimps for makes. Whether you go broke, have enough for your retirement, etc. is irrelevant to him as long as the suckers keep his game going.As my paternal grandfather said, "If you don't have the money to buy it, you have no business buying it". Hitting the half century mark in life, I can see the wisdom in that adage.P.S. I have read the book "The Millionare Next Door" and don't remember where it recommended to get in to debt inorder to invest in other areas of the financial world.

sorry blanket and lance, you didnt really get what he said. he didnt say "If you paid your mortgage off EARLY, it means you probably did not manage your funds efficiently over the years." he was saying that it should NEVER be paid off, as in, after 29 years and almost paying it off, sell it and UPGRADE to a new house so you can keep paying a mortgage, and by selling and rebuying you, of course, use an agent and help out the NAR cause...

anon 7:57 ... If you are looking at it purely from a financial perspective it doesn't make sense to ever payoff or paydown your mortgage. Your home isn't an investment vehicle, it is an expense. You want to spend the least possible on it possible over the longhaul. Having a high mortgage at a low rate is the ideal. That means less funds put into the house over the longrun and more available for other investments such as bluechip stocks that will give you a better return. Additionally, the higher the mortgage, the higher the tax deductible mortgage interest. Looked at simplistically, if you can "borrow" $100,000 from your house's equity at 6% and invest it in safe bluechip stocks and get 10%, aren't you better off? Again the objective is to minimize your housing costs over the longhaul even if it means renting. Historically though, renting has not been cheaper over the longhaul as rents always go up ...

This is the point of the Millionaire Next Door - live below your means, don't compete with the Jones' family, forego the fancy new cars and clothes.

We're going to make a bubblehead of you, yet, VaInvestor. ;)

I would extend your advice to not buying a house at the top of the biggest U.S. RE bubble ever just for the sake of "getting into something", but to save your money for an even bigger downpayment on something in about three or four years when things are back to rationality, or at least something approaching rationality.

Long-term, you're almost always better off owning, but short-term is a different story right now.

Another thing about VAinvestor's wise comment. If your life is all about acquiring the most Konsumer Krap you can, then you don't have much of a life.

A Toyota Camry gets you from A-->B just as well (and probably more reliably) than an S-Class Mercedes. Inexpensive clothes keep you warm and non-exposed just as well as fancy clothes. A big screen TV just makes you waste more of the precious moments of your life watching other people do stuff rather than doing stuff yourself.

Exceptions: don't scrimp on comfortable shoes and beds. Less is definitely not more when it comes to ergonomic sorts of things.

You sort of proved my point when you said how good it felt to pay off your mortgage. I am sure that it feels terrific. But that is emotional reasoning, not financial.

Most advisors would not recommend "getting into debt" to invest either. But a mortgage (and other large loans) are a different situation. Can you imagine the financial folly in paying $200K up-front for a house in order to avoid debt? That $200K would then be locked up with no way to access it unless you 1. Sold your home 2. Took on debt through a HELOC. Neither would be an option if you were to lose your job.

I believe that the book "millionaire Next Door" found that virtually all of these people own their homes. The difference is that they do not constantly "trade-up" but tend to stay in the same place for 30 years and have it paid for.

They could "afford" 3 or 4 times as much house, but choose not to. They drink Bud instead of single-malt and drive a 6 year old chevy.

This is why they have millions. They don't belong to the fancy clubs and don't care what the neighbors think. Chances are their neighbors are blue-collar people.

Most advisors would not recommend "getting into debt" to invest either. But a mortgage (and other large loans) are a different situation. Can you imagine the financial folly in paying $200K up-front for a house in order to avoid debt? That $200K would then be locked up with no way to access it ...

But that assumes that you never make another dime in your life. If you can pay cash upfront for your shelter, all of that money that would have gone down the drain to pay interest can be put into investments.

Now, I will agree that waiting decades to buy a house until you have 100% of the money is typically not the best decision if you can afford to buy a house now under traditional sound lending principles, simply because you do acquire equity over time, and you should still have money left for investment if you are only paying 25-28% of your income in housing costs. But these folks using toxic loans or paying 50-60% of their income just to "get into something" are almost universally making a foolish decision.

Let me get this correct. If I am to be a sophisticated investor then I should take a cash-out refi and invest that in something that will return more than appreciation on my home?I got 1oo% in 6 years on the house, but that is over. With low interest rates I can refi and invest that into the next bubble.Keep riding the wave.

In order for your scenario to be remotely plausible (i.e., not paying off mortgage debt in favor of investing the capital one would have used to make the payoff) you have to assume that the return on your investment for the next 30 years would be greater than the debt servicing of the mortgage.

Aside from the brass cajones it takes to make that assumption, I'm wondering what data you guys are using to justify this, especially given the current abnormally low mortgage inteest rates.

whitetower asked:"Aside from the brass cajones it takes to make that assumption, I'm wondering what data you guys are using to justify this, especially given the current abnormally low mortgage inteest rates."

Shiller's study, of course! The "return" on your house is only 1% above inflation, right? So, the less cash you put in your house, the more you have to invest elsewhere. Yes, you have to take into account what you are paying to borrow that which you otherwise would have paid for. Bottom, line is if you have a locked in longterm mortgage at something like 5%, how could you not be better off paying the 5% there and getting a higher return rate with Treasury Bonds or a blue chip stock? Over the long run blue chips return something like 10% ... BUT, yes, there is some risk in this. It's possible the US government defaults on its obligations or that a blue chip company such as IBM goes under ... It's just not very likely ... or even "a little" likely ...

I noticed the point, made by one of the anonymi, that to justify having a paid off house, you have to accept that the return is equal only to the value of the lost rent. That's a fair point and I do, in fact, accept that foregone rent is my opportunity cost. Let's assume that current optimal rent is 1% of the value of the house; to be a good sport, I assume that I would actually receive only only half that, 0.5%, which becomes my opportunity cost. That yields me 6% per year, tax-free. It is a sure thing; how many other tax-free riskless investments earn more than that, year in and year out, while I am out fishing and not watching my laptop?

"Bottom, line is if you have a locked in longterm mortgage at something like 5%..."

There is nobody who has 5% 30-year mortgage interest rates. Mortgage interest rates have never been this low.

(The historical average, if memory serves me, is closer to 9%.)

So the "safe" T-bill strategy won't yield a higher return than the mortgage debt servicing.

And there's the rub: you are making taking a terrible risk that your investment returns will warrant servicing 30 years of mortgage debt. Indeed, you may end up with zero returns (e.g "dot-coms"), but you will still have the mortgage debt.

I paid off my house and do not believe it is the time to invest in both RE and stock markets. None can be sure you can get 8% return to bet on Stocks right now. What else I can do here? Put the money in CD for 5% and pay mortgage at 6%. It doesn't make sense.

Time equals money. You can never have as much as you could have if you are playing catch-up after the mortgage is paid off. A simple compounding interest calculator will show how. An extra $100 per month over 30 years really adds up. The true question is - do you want these funds liquid or illiquid (i.e., in your house)?

Secondly, an inability to "not spend" your liquid assets has no bearing on a financial equation. While it is good that you can acknowledge your lack of discipline, it does not make it wise financially.

Additionally - calling long-term stock market investing (30 year periods, like your mortgage) 'gambling' is ignorant. Long term you will do better in equities, period. Pre-paying a mortgage, especially at today's low rates makes no sense.

As Edelman says "When people tell me their house is the best investment they ever made, it is usually the only investment they ever made."

I don’t mean to come down too hard on people’s decisions regarding their mortgages – there are a lot of emotions involved in carrying debt and many good feelings engendered when one has their house paid off. I don’t mean to dismiss that.

Lance-"invest it in safe blue-chip stocks and get ten percent".Do you realize that hedge fund managers get paid to TRY and achive ten percent? Do you realize how valuable a ten percent yield is right now? How old are you? Corporate, junk and government yield spreads are at their historical lows right now. Doesn't that tell you something? Before you "throw" around statements with impunity regarding ten percent yields, make sure you know who you're audience is. That statement could work with some individuals, say the one's who purchase time shares, however, it will only make you look like a fool to most others. Let's see, take out a HELOC at six and get ten. Easy. Noooo problem. In today's environment, more so than ever, that is simply gambling. No different than taking that HELOC to Vegas. Ten percent yield. No problem. Friggin' unbelieveable.

Where are safe blue-chip stocks and get ten percent? It is a joke, especially in current market. The market has been flat for almost 5 years, and there is no sign it will go up in the near future. At least, just like RE market, it is not the time to get into stock market. The best option right now for the time being is to pay off your house.

warmredblanket said... "Additionally - calling long-term stock market investing (30 year periods, like your mortgage) 'gambling' is ignorant. Long term you will do better in equities, period. Pre-paying a mortgage, especially at today's low rates makes no sense."

Yes, long-term RE investment (30 years?)will definitely have a much better returen than current mortgage rate (6%). Why don't you just jump in to buy a few invest homes today and you will make a lot of money after 30 years.

Do you also think now is right entry point to jump into the stock market ?

First, I think I need to clarify. I am in no way recommending that people take out HELOCs in order to buy stocks. That seems very similar to buying on margin - except it is your home! What I am actually saying is - view your home as an expense, do whatever you can to keep that monthly expense low from the very start so that you can invest in other things and take advantage of compounding interest over time, do not pre-pay a mortgage, etc.

Regarding stocks - I guess the misunderstanding is that I am not talking about the "next few years." Not sure that I worry about how stocks will do next year, I worry about where mine will be 5 years from now or 10. This is a long term strategy but it's relevant because we are talking about mortgages, which last for 30 years.

Trying to jump from the latest trend to the next is how people end up with not much in the end. Buying stocks because of the morning talk on SquawkBox is one step away from day trading. (And not just because few people are that skilled at timing the market, but because all those transaction fees/capital gains taxes add up). Think long term for the long haul. As your portfolio grows and you have a cushion, you can try some riskier investments. Something you should never do if you are in your 40s/50s and trying to catch up for retirement. Which could easily happen if you spent your 20s and 30s paying down your mortgage.

Va - I am not sure I would say a mortgage is "as good a place as any." Clearly there would be some stocks (if you could pick the right ones) that would earn a better return than your mortgage rate. But if you are diversified (but not overly diversified - that spoils returns as well), I guess it would depend on how low that mortgage rate is and how many more years you have to pay on it. Basically any investment that would put you ahead of your mortgage rate would be better. But if nothing out there is earning those returns and you only have a few years left to play with...go ahead, pay it down, I’m neutral on that.

I guess my main point is it takes patience! If you are looking to double your money every 2 years you will be dissatisfied. But we are talking about 30 years. Eventually the mortgage will get paid off - but will you pay it off in 25 and have a little $ on the side? Or will you pay it off in 30 and have that much more, liquid, spendable assets?

people who don't overextend can pay-off their mortgage in 15yrs and still sock away a ton of dough for retirement. It is called living beneath your means.

It’s not about can, it’s about should. Of course, some people can do both. But we are discussing which will result in the most liquid, accessible, spendable money in your portfolio in the end.

I suppose one could wait until age 40 to buy and have the mortgage paid off at 70. That thought makes me ill.

Why? This is a very emotional reaction. If the renters spend from their 20-40s investing wisely, they have an awesome nest egg. (This strategy works especially well if renting is half the cost of buying, and there are minimal annual rent increases). When they do buy, they put down their 20% to avoid their PMI (keep their housing expense low) and happily pay their ever-smaller (due to the effects of inflation) mortgage until they are 70. Meanwhile they continue to invest and therefore have all the liquid $ they want/need to go on vacation, pay for college etc., …instead of having to sell their house, or take out a HELOC to get at it.

Once again, people assign a lot of emotional weight to having the massive cloud of mortgage debt hanging over them. Understandable, but this is a holdover from long ago, when a bank could call your mortgage due in full all at once. (That has since been outlawed.) You will never catch up if you wait to invest. Keep your expenses (including your housing expense) low so that you can invest now.

I never suggested that you wait to invest for retirement; in fact, I said the opposite.

I would be hard-pressed to believe renters are saving vast amounts of money for retirement. I would think that people tend to spend whatever is available. Just look at the savings rate; which is lower for renters than owners.

I can only say that in my 20's what money came in, went out. Thankfully, we fully funded all retirement vehicles and bought a house.

The renters on this site are probably the exception to the rule. I still say that you can do both by tightening the belt some.

Once again, this has no bearing on a mathematical equation. I am in my 20s, maxing out all retirement vehicles, and investing my savings from renting. (While I agree that the renters like myself on this board are the exception to the rule.) The good news is that compounding interest works for everyone, including more 'typical' renters, or those with a low socioeconomic status.

Mortgages are forced savings for those who spend whatever they have. But that doesn't mean that using your house as your savings vehicle is the best thing to do. The best thing to do is to evaluate the options and then be disciplined enough to follow through on the superior plan.

Finally, the reason it sounds either/or, is that for many 20-somethings, with housing as expensive as it is currently, it is either/ or. Most importantly, there is the high mortgage cost because there is no denying that owning cost more - a lot more-- than renting in the DC area. The softer side of the equation is that when a 20-something buys their house, there are additional expenses that come along-- furnishing, painting, maintaining, maybe even entertaining more. The $ flies out the door. Investing takes a back seat at the time when it can matter most (early on).

I understand that you are sitting pretty now and feel good about where you are at. I think that’s great. I also contend that you could have done a lot better if you had made different decisions. At the same time, if you have all you want, no need to be greedy right? My point is not to make those who are set regret their decisions – it is to help those who are starting out maximize their financial potential.

It is either/or if you set your sights too high. Buy a fixer-upper "starter" home. People can do both. Own a home AND max-out retirement investments.

Forego the new furniture. Forego all the entertaining for a year or two until you get a few raises.

Look at the broad numbers, rent or own, people do not save enough. You say save now and buy a house later. I say buy as soon as you can afford it and save for retirement too. A house should definately come before college savings. You agree with that I hope?

I believe the concept of a 'starter home' is a fallacy. 'Starter home' implies you will move out of it within 5-10 years, right?

Now consider the two sets of closing costs, realtor commissions, neighborhood association/condo fees, property taxes, and the bare minimum in maintenance. You have already spent 10s of thousands of dollars on your 'starter' home. Now you want to move up? Are you sure the house will appreciate by your sunk costs plus more within the 5-10 years? Remember early on in your loan, you are building very little equity. Will it be enough to cover the above costs and provide the necessary equity for the move-up? In today's environment, almost no one would call that a guarantee.

Even sweat equity costs something in materials. Besides, now you are referring to refreshing or upgrades which only increases your 'investment' (i.e. expense) in the starter home. My expenses did not even consider trying to fix a place up. Once again, the point is to keep your housing expense low.

Secondly, if I keep the starter home as a rental how do I get the equity out of it for the next home? (I don't have much else for the next place - remember the cost of a current 'starter' home in the DC area left me with almost nothing to invest in liquid funds - and I am not referring to my 401K.)

I also think this dialouge is over. I'm not sure there is that much more to add. We just disagree - that's cool.

Think back to your first fixer upper. What did it take to get the mortgage for the second home when you kept the first as a rental?

I'm guessing that the rate did not increase on the first (as it is now an investment property) since that bank would probably never know the difference as long as they got their check. What about the new mortgage though? Did you have additional cash for the 20% downpayment or are you able to use the existing home's equity as collateral?

We always got 95% financing in the early years. In some cases we went FHA with only 3% down. The loan terms do not change when you convert to a rental.

In some cases, I obtained credit lines to purchase new properties. We flipped a couple of places in the 80's that netted us alot of cash.

It was only hard to come-up with the money for the first 2 or 3 places. We didn't have any money back then. We had the seller's pay all allowable closing costs and also provide cash-back through a "decorating allowance". I don't know if those "allowances" are permitted today, but they let get into a house with virtually zero down.

Many people have missed the point. Financially speaking, locking hundreds of thousands up in your house is in fact one of the biggest mistakes you can make.

Anon at 3:05 on Sept 14 said "...I should take a cash-out refi and invest that in something that will return more than appreciation on my home?"

Appreciation on your home has absolutely nothing to do with it. Your home will appreciate at the same rate whether you own it free and clear or have an 80% mortgage with a 20% second. A mortgage is the cheapest money you will ever get. Especially if you have a 30-year lock from several years ago and are somewhere around 5.5% to 6.5%, you will be far better off in the long run if you invest that in something that is likely to beat 4.0 to 4.5%, the after-tax cost of the mortgage. Over a 30-year span, there are plenty of investments that are likely (not guaranteed, but nothing is) to do that. So you come out ahead on the mortgage, and you still have whatever gains your house gets.

It's just math, and rather straightforward. Lereah may or may not be right about much, but he's right about this.